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(^298) Financial Management
The expansion stage is the next stage, during which the strong companies survive the
competitive struggle and aim to expand their market share and volumes. During this
stage, huge investments are made to expand production/service capacity. Requirement
of funds is high during this stage. Subject to the corporate strategy of funding projects
and the market conditions, the company may raise capital at the lowest possible cost.
As the earnings stabilise, the company will be in a position to weather any small variations
in business, then it can seek to financially leverage itself within a pre-fixed ceiling, by
bank loans or financial institutional loans. It is during this stage that companies are
typically expected to reward their investors with dividend and stock dividend/splits.
Stabilisation/stagnation stage is the last and final stage. A dynamic management will
always be on the lookout for expansion/diversification into new projects. It could, again
depending on corporate strategy, go in for green-field projects or take over existing
units, seek mergers, acquisitions and strategic alliances, etc. Usually a recession in
economy opens up a vast number of such opportunities which cash rich companies can
take advantage of. In case of lack of such opportunities, the company could reduce the
financial leverage and save on interest and if possible down size the equity by buy back
of shares. Buy back of shares acts to boost investor confidence in the company and
also makes equity serviceable during recession.
EBIT - EPS Analysis & ROI - ROE Analysis
As a method to study the effect of leverage on capital structure, EBIT - EPS analysis
essentially involves the comparison of alternative methods of financing under various
assumptions of EBIT. A firm has the choice to raise funds for financing its investment
proposals from different sources in different proportions. For instance, it can (i)
exclusively use equity capital (ii) exclusively use debt, (iii) exclusively use preference
capital, (iv) use a combination of (i) and (ii) in different proportions; (v) a combination
of (i), (ii) and (iii) in different proportions, (vi) a combination of (i) and (iii) in different
proportions, and so on. The choice of the combination of the various sources would be
one which, given the level of earnings before interest and taxes, would ensure the
largest EPS. Consider Example 4.3.
Suppose a company has a capital structure exclusively comprising of equity shares
amounting to Rs.10,00,000. The firm now wishes to raise additional Rs. 10,00,000 for
expansion. The firm has various alternatives, three of them are given below:
(A) It can raise the entire amount in the form of equity capital.
(B) It can raise 50 per cent as equity capital and 50 per cent as 5% debentures.
(C) It can raise the entire amount as 6% debentures.
Further assume that the existing EBIT is Rs.1,20,000, the tax rate is 35 per cent,
outstanding shares 10,000 and the market price per share is Rs.100 under all the three
alternatives.